This blog is a commentary on contemporary business, politics, economics, society, and culture, based on the values of Reason, Rational Self-Interest, and Laissez-Faire Capitalism. Its intellectual foundations are Ayn Rand's philosophy of Objectivism and the theory of the Austrian and British Classical schools of economics as expressed in the writings of Mises, Böhm-Bawerk, Menger, Ricardo, Smith, James and John Stuart Mill, Bastiat, and Hazlitt, and in my own writings.

Monday, January 10, 2011

Labor unions like to argue that the payment of higher wages is to the self-interest of employers because the wage earners will use their higher wages to make additional purchases from business firms, thereby increasing the sales revenues and profits of business firms. However, wrong and foolish it may be, this is an argument worth analyzing in some detail, because it can provide a gateway to a discussion of the actual sources of profit in the economic system.

The union argument, of course, ignores the fact that the business firms paying the higher wages and those earning the additional sales revenues and profits that are alleged to result are likely to be different firms. Indeed, insofar as any one, individual firm is considered, this will certainly be the case, if for no other reason than that very little, if any, of the additional wages paid by that one firm are likely to be expended by its employees in purchasing goods specifically from it. Whatever kind of firm it may be, it specializes in just one or, at most, a very few kinds of business. Yet its employees will almost certainly expend their higher wages in buying a wide variety of products, from a wide variety of firms.

The only way that an individual firm might expect to gain comparable additional sales revenues following its payment of additional wages is if the payment of additional wages takes place on the part of very many firms, throughout the economic system. In that case, while its employees spend most or all of their additional wages in buying from other firms, the employees of other firms may very possibly spend enough of their additional wages in buying from it, to provide it with additional sales revenues sufficient to match its additional payment of wages.

But even in this case, firms producing capital goods will not have additional sales revenues. This is because, in the nature of the case, all of the additional sales revenues accrue to the sellers of consumers’ goods. For it is consumers’ goods on which the additional wages are expended, not capital goods. All that the sellers of capital goods will have is additional costs of production, corresponding to their payment of additional wages.

Indeed, in any circumstances, even in the highly unrealistic case in which all firms sold nothing but consumers’ goods, there would be additional costs of production equal to the additional wages paid. The additional wages sooner or later always show up as equivalent additional costs of production. The consequence of additional costs of production equal to the payment of additional wages offsets the existence of additional sales revenues equal to the payment of additional wages.

Insofar as the effect of the payment of additional wages is the combination of additional sales revenues and additional costs of production, there can be no increase in profits in the economic system. In both being equal to the same thing—viz., the additional wages paid—the additional sales revenues and the additional costs are equal to each other. In the face of equal additions to sales revenues and costs, profits, the difference between sales revenues and costs, remain unchanged in the economic system in terms of their dollar amount. Equals added to unequals not only do not affect the amount of the inequality, but serve to reduce the percentage that the unchanged amount of profit constitutes of the now larger sales revenues and costs. Profit as a percentage of sales revenues and cost necessarily declines.

Furthermore, while it is not unreasonable to assume that the payment of additional wages results in equivalent additional expenditure by the wage earners and thus in equivalent additional sales revenues for sellers of consumers’ goods, it is by no means the case that it must result in an equivalent additional expenditure and sales revenues in the aggregate, i.e., for consumers’ goods and capital goods taken together. It might well be the case that the additional payment of wages comes at the expense of purchases of capital goods, notably the materials and machinery business firms buy. In that case, aggregate sales revenues in the economic system will be unchanged.

And if this is the case, then it is almost certain that business profits in the aggregate will substantially decline in amount as the result of an increase in wage payments. This is because expenditures for capital goods, especially machinery and buildings, show up as costs of production in business income statements much more slowly than do wage payments of equivalent amount. For example, an additional $1 billion of expenditure on wage payments is likely to show up as costs of production within a matter of weeks or months. However, that same $1 billion expended on machinery or buildings will show up as equivalent costs of production only over a period of years or even decades, as the machinery or buildings undergo depreciation.

Consequently, a shift in expenditure from machinery and buildings to wage payments would result in an increase in aggregate costs of production in the economic system in the current year, and many years thereafter, of the far greater part of the $1 billion. Profits in the economic system would equivalently fall because, in the conditions of the case, the increase in aggregate costs would occur in the face of aggregate sales revenues that were unchanged.

It should be realized here that by the same token, a decline in wage payments that made possible an equivalent rise in the expenditure for machinery or buildings would result in a substantial increase in profits in the economic system. This is because, in this case, aggregate costs of production in the economic system would fall as depreciation cost, representing a relatively modest fraction of the additional $1 billion that was now spent on machinery or buildings, replaced what would have been current operating costs representing the far greater part or all of the $1 billion otherwise spent in paying wages.

This conclusion, of course, flies in the face of the views of the labor unions and the Keynesians, who believe that reductions in wage rates reduce business profits insofar as they result in a reduction in total wage payments and consequently consumer spending. The truth, as I have just shown, is the exact opposite insofar as the reduction in wage payments serves to increase expenditure for durable capital goods.

Profits and the Average Period of Production

There is an abstract principle that is present in these examples, one that relates to the “Austrian” concept of the average period of production and the closely related Ricardian concept of the necessary lapse of time that takes place between expenditures for means of production and the receipt of proceeds from the sale of the ultimate consumers’ goods that result. The principle is that, other things being equal, a lengthening of the average-period-of-production/necessary-lapse-of-time brings about a transitory decrease in aggregate costs of production in the economic system and increase in profits in the economic system. By the same token, other things being equal, a shortening of the average-period-of-production/necessary-lapse-of-time brings about an increase in aggregate costs of production in the economic systems and decrease in profits in the economic system.

I describe the change in aggregate costs of production as “transitory” because ultimately, if the amount of spending for means of production, i.e., labor and capital goods, remains the same in the economic system year after year, costs of production will equal that amount of spending, irrespective of the length of the average-period-of-production/necessary-lapse-of-time. For example, on the scale of an individual company, $1 billion per year expended on labor and materials will probably result in $1 billion of annual costs of production for that company within little more than a year. That same $1 billion expended year after year in purchasing machinery with a depreciable life of 10 years, will result in annual depreciation costs of $1 billion after 10 years. At that point, 10 years’ of machinery purchases will be in place, with the purchases of each year resulting in $100 million of annual depreciation cost, or $1 billion in all. Similarly, the expenditure of $1 billion year after year for buildings with a 40-year depreciable life must result in $1 billion of annual depreciation cost once 40 years have passed. At that point, there will have been 40 years of building purchases. With each of those 40 years’ purchases resulting in an annual depreciation cost of one-fortieth of $1 billion, the total annual depreciation cost from than point on will be $1 billion.

So long as further lengthening of the average-period-of-production/necessary-lapse-of-time occurs, the process makes a further contribution to aggregate profitability. But once further lengthening ceases, the contribution to aggregate profitability comes to an end. (Mises implicitly recognizes the contribution to aggregate profit made by a lengthening of the period of production. See Human Action, 3d ed. rev. [Chicago: Henry Regnery Co., 1966], pp. 294-97.)

Profits and the Increase in the Quantity of Money/Volume of Spending

Nevertheless, there is a second factor connected with the passage of time in the productive process that can be gleaned from our discussion of the union argument concerning wage payments, and whose contribution to aggregate profitability is capable of being permanent. This factor is the increase in the quantity of money/volume of spending in the economic system.

The increase in wage payments so much desired by the unions could make a contribution to aggregate profits in the economic system insofar as it was financed by an increase in the quantity of money. (A decrease in the demand for money for cash holding would also have this effect. However, inasmuch as decreases in the demand for money for cash holding cannot go on indefinitely and, indeed, ultimately depend on increases in the quantity of money, they require no further separate discussion.)

Moreover, what serves to contribute to profits in the economic system here is in no way peculiar to higher wage payments. It is present equally in greater expenditures for materials and supplies and machinery and buildings, i.e., in greater expenditures for means of production as such.

The contribution to profits in the economic system derives from the fact that additional expenditures for means of production resulting from the increase in the quantity of money serve to raise sales revenues in the economic system immediately or almost immediately while they serve to increase the costs of production deducted from sales revenues only with a more or less considerable time lag. Thus, what business firms spend in buying capital goods is simultaneously sales revenues to the sellers of the capital goods. What they spend in paying wages shows up very quickly as additional sales revenues for sellers of consumers’ goods.

Consistent with the principles of business accounting, in the case of all goods sold out of inventory, additional costs of production appear in business income statements only as and when the goods produced from the means of production purchased for larger sums of money are sold. That often entails a lapse of time of several months, and, sometimes, several years. For example, the additional expenditures made by an automobile company for labor and materials will not show up as costs of production until the automobiles produced in the process are actually sold, at which time cost of goods sold is incurred. Such outlays made in November or December of a calendar year will not show up in the auto firms’ current-year income statements ending on December 31, but only in the income statements of the following year.

In the case of a distillery, producing aged whiskey, such time interval may be 8, 12, or 20 years, or even more. Of course, in the case of the machinery and buildings purchased by business firms, major time intervals are present everywhere before additional depreciation cost comes to equal the additional outlays.

In these intervals, sales revenues are increased without costs being increased, or increased equivalently, and thus profit emerges. And then, if the increase in the quantity of money and volume of spending is continuous, by the time costs do rise to reflect the higher level of expenditures made in purchasing the means of production, there are further increases in the expenditures for the means of production and thus in sales revenues. In other words, there is a continuing contribution to aggregate profit.

It follows from this discussion that a continuing given percentage increase in the quantity of money/volume of spending in the economic system tends to add an approximately equivalent percentage increase to the economy-wide average rate of profit/interest. For example, a continuing 2 percent annual increase tends to add approximately 2 percentage points to the rate of profit/interest on top of what it would otherwise have been. This conclusion follows by conceiving of outlays for means of production in any given year as being paired with receipts from the sale of consumers’ goods in definite future years. If the volume of spending and thus of sales revenues in the economic system were growing at some definite compound annual rate, an equivalent additional rate of return on those outlays would be implied.

For example, if with no increase in the quantity of money/volume of spending, an outlay for means of production of 10 would grow to sales revenues of 11 in a year, but now a 2 percent increase in money and spending makes it grow to 11.22, the rate of return on the outlay of 10 is increased from 10 percent to 12.2 percent, an increase of approximately 2 percentage points. In the same, way an outlay of 10 that would otherwise grow to (11/10) x (11/10) in 2 years, will now, with a compound annual increase of 2 percent in money and spending, grow to (11/10) x (11/10) x 1.02 x 1.02. Again, on an annualized basis, there will be an addition of approximately 2 percentage points to the rate of return. Since every dollar of sales revenues in the economic system can conceptually be paired with outlays for means of production made at one specific time or another in the past, a uniform compound annual increase in money and spending covering the entire time interval must have this effect everywhere.

The increase in the rate of return resulting from the increase in the quantity of money/volume of spending should not be dismissed as inflation. In a free market, under a gold standard, the quantity of money would increase and that increase, as Rothbard has convincingly shown, would not be inflation. Inflation, Rothbard showed, applies only to increases in the quantity of money more rapid than increases in the supply of gold. The modest increase in the quantity of money in a free economy and its gold standard would almost certainly be accompanied by increases in the production and supply of commodities in general that were at least as great and, most probably, significantly greater. The result would be falling prices. However, and this is a very significant finding, these falling prices would not at all be deflationary, because, as I have just shown, they would be accompanied by an increase in the average rate of return on capital rather than a decrease, which last is a leading symptom of any actual deflation.

In a free market and its gold standard, a reasonable scenario would be a 2 percent annual increase in the quantity of gold and spending in terms of gold, accompanied by a 3 or 4 percent annual increase in production and supply in general. The effect would be prices falling at an annual rate of 1 or 2 percent along with an approximate 2 percent addition to the average rate of return. The real rate of return, of course, would be elevated further, to the extent that prices fell.

There is a further very important conclusion to be drawn here, concerning the actual significance of the rate of return, the rate of profit/interest. And that is that to a very significant extent, the nominal rate of return is the reflection of nothing more than the increase in the quantity of money and volume of spending, while the real rate of return is the reflection of nothing more than the rate of increase in production and supply. In other words, at least to this extent, the rate of return cannot possibly be at anyone’s expense. It is the accompaniment and marker of more gold and of more goods in general, i.e., of economic progress and general improvement.

It must be pointed out that profits derived from lengthenings of the average period of production are also ultimately at no one's expense. To the contrary, in adding to the total of the capital employed in the economic system, they serve to increase the quantity and quality of the products produced. To the extent that these products are consumers' goods, the effect is a rise in real wages inasmuch as they are purchased overwhelmingly by wage earners. To the extent that the larger supply of products produced is capital goods, it serves to bring about a further increase in the supply of consumers' goods, and thus in real wages, and yet a further increase in the supply of capital goods, which in turn will have the same result. Continuing increases in the supply both of consumers' goods and capital goods, and thus continuing increases in real wages can occur.

The Rate of Return Under a Fixed Quantity of Money/Volume of Spending

In addition to increases in the quantity of money/volume of spending and lengthenings of the average period of production, there is a third source of profit in the economic system. This is the consumption expenditure of businessmen/capitalists, i.e., the expenditure of businessmen/capitalists that is not for business purposes, not for the purpose of making subsequent sales.

Like the consumption expenditure of wage earners, this expenditure is a source of business sales revenues in the economic system. But, unlike the consumption expenditure of wage earners, it has no counterpart in expenditures that generate costs of production. Its sources are primarily dividends paid by corporations and the draw of funds from partnerships and sole proprietorships. These payments do not show up as costs of production on the part of the firms that pay them. They are simply a transfer of funds from the firms to their owner(s).

Their existence enables business sales revenues in the economic system to exceed the expenditures by business firms for means of production and thus also to exceed the equivalent costs of production generated by those expenditures. In this way, they are a source of profit in the economic system.

Interest payments by business firms are also a source of funds making possible consumption expenditure by businessmen/capitalists. Interest payments, of course, do show up equivalently in costs of production. Nevertheless, their existence helps to explain the existence of business profits pre-deduction of interest. And thus they help to explain the general rate of return on capital, which is calculated gross of interest. This rate of return—the rate of profit pre-deduction of interest—of course, is what determines the rate of interest. (In the terminology of Mises and most other economists of the “Austrian School,” these profits are called “originary interest.” Taken relative to capital invested, they constitute the rate of originary interest.)

Profits resulting from the consumption expenditure of businessmen/capitalists would exist in the absence of further increases in the quantity of money/volume of spending. Their existence, moreover, acts to put an end to any indefinite prolongation of the average period of production. This is because, to be worthwhile, a lengthening of the average period of production requires that businessmen find that the investment of additional capital results in cost savings or revenue increases at the level of the individual firm sufficient to yield something more than the prevailing rate of return on capital. Thus, the higher is the prevailing rate of return, the greater is the obstacle in the way of additional investment being worthwhile. At the same time, the greater is the volume of capital that has already been accumulated in the economic system relative to sales revenues, the smaller is the contribution to costs savings or revenue increases that is likely to be made by the investment of still more capital and a further rise in the ratio of accumulated capital to sales revenues.

The implication of this discussion is that ultimately the rate of return in the economic system is determined by the combination of the rate of increase in the quantity of money/volume of spending and the ratio of the consumption expenditure of businessmen/capitalists to their accumulated capitals.

The second factor is clearly the more fundamental and should be understood as a reflection of time preference. In conditions in which the annual consumption expenditure of businessmen/capitalists is on the order of 5 percent of their accumulated capitals, time preference is lower than in conditions in which it is on the order of 10 percent of their accumulated capitals. It is lower still in conditions in which it is on the order of 2 percent. In the first case, their capitals are sufficient to provide for the consumption of 20 years; in the second, for only 10 years; in the third, for 50 years. A lower time preference is required to make greater relative provision for the future.

Establishing the relationship between time preference and the consumption expenditure of businessmen/capitalists relative to their capitals and, on that basis, to the rate of return on capital, serves to integrate time preference and its determination of the rate of return into “macroeconomics.”

Avoiding Confusions

It’s necessary to anticipate two possible confusions that may arise. One is the conviction that the claim that the consumption of businessmen/capitalists is a determinant of the rate of return on capital implies that to increase its rate of return, a company should increase its dividends and simply be sure that its stockholders consume the proceeds.

If enacted such a policy would, to some very modest extent, serve to increase the economy-wide average rate of return on capital. But the profits earned by the firm in question would be decimated. The extra profits would go to others, not to it. This is because such behavior would reduce its capital, which is an essential means of its competing for profits, by far more than it increased the economy-wide amount of profit.

For example, a huge firm, with a capital of $100 billion might increase its dividend by $10 billion and add $10 billion to the excess of sales revenues over expenditure for means of production in the economic system, and over costs equal to the now reduced expenditure for means of production. This would increase economy-wide profits from, say, $1 trillion to $1.01 trillion, a 1 percent increase. But at the same time, it would reduce the capital of this firm by 10 percent. Thus, the firm would be in a position to compete for its share of a 1 percent increase in profits in the economic system on the foundation of a capital that had been reduced by 10 percent. The profit it earned would thus certainly be much lower than it was before.

The second confusion that may arise is to ignore the fact that the discussion of profit in this article has been almost entirely at the level of the economic system as a whole, not at the level of the individual firm. As indicated in the last paragraph, competition exists at the level of the individual firm and plays a decisive role in determining its profits. Such factors as its relative efficiency and the relative quality of its products are vital for the profitability of the individual firm, but play little or no role in determining profits at the level of the economic system as a whole. This is because there competitive factors cancel out.

Summary

The central question that this article has been concerned with is what permits an excess of sales revenues over costs of production in the economic system as a whole. Here, as we have just seen, such things as producing a larger quantity of products more efficiently, or producing better products that can command premium prices, simply do not provide an explanation. This is because at the level of the economic system as a whole, they cancel out, with the profits of the more efficient, higher quality firms matched by the losses of the less efficient, lower quality firms.

The explanation of profit/interest in the economic system as a whole is provided by:

1) A shifting of expenditures for means of production from products and processes in which they show up more quickly as costs of production to be deducted from sales revenues, to products and processes in which they show up more slowly as costs of production to be deducted from sales revenues. In both cases, the same expenditure for means of production generates the same volume of sales revenues in the economic system, but in the second case costs are lower for a more or less considerable period of time, and thus profits are higher for that period of time. This, of course, represents a lengthening of the average period of production.

2) The increase in the quantity of money/volume of spending. This increase serves to increase sales revenues immediately or almost immediately while increasing the costs deducted from the sales revenues only with more or less substantial time lags. In the interval, profits are generated. The process is perpetuated by continuing increases in the quantity of money/volume of spending. At the same time that more money and spending add to profits and the rate of profit in terms of money, increases in the production and supply of ordinary goods can serve to prevent price increases or even result in price decreases, with the result that the nominal profits generated are accompanied by equivalent or greater real profits. This would be the situation in a free market and the gold standard.

3) The consumption expenditure of businessmen/capitalists. This is the source of sales revenues in excess of expenditure for means of production and of costs of production equal to those expenditures. It is the most fundamental source of profit in the economic system and ultimately rests on time preference.

Further Development of the Theory of Profit/Interest

I discuss all aspects of the present article at greater length, along with a host of other, related matters as well, in my book Capitalism: A Treatise on Economics. It will be helpful to provide a short bridge from this article to that book, in the form of the introduction of some new terminology.

In Capitalism, I refer to expenditure for means of production by business firms as productive expenditure, which is expenditure for the purpose of making subsequent sales. Productive expenditure is in sharpest contrast to consumption expenditure, which is expenditure not for the purpose of making subsequent sales, but for any other purpose.

Productive expenditure, of course, has two components: expenditure for capital goods and expenditure for labor—i.e., wage payments. Productive expenditure plays a twofold role in the generation of aggregate business profits: it is the source both of most of business sales revenues and of the costs business firms deduct from their sales revenues.

Productive expenditure can exceed costs deducted from sales revenues insofar as the costs it generates follow it with time lags. To the extent it does exceed costs, the sales revenues it generates also exceed those costs. There is profit.

Any excess of productive expenditure over costs is net investment. This is because, in accordance with the principles of business accounting, productive expenditure to a substantial extent constitutes additions to business asset accounts, notably, the gross plant and equipment and inventory/work in progress accounts. Expenditures on account of machinery or buildings add to the former; expenditures for materials add to the latter. Expenditures even for labor often represent additions to these accounts—for example the wages paid to workers constructing plant or to workers employed in the production of inventories.

Costs of production, on the other hand, largely represent subtractions from these accounts. Depreciation cost is a subtraction from gross plant and equipment. Cost of goods sold is a subtraction from inventory/work in progress. Thus, while productive expenditure adds to the asset accounts of business, cost of production subtracts from them. The difference between the sum of the additions and the sum of the subtractions is the net change, i.e., net investment.

Net investment reflects the effect both of changes in the length of the average period of production and changes in the quantity of money/volume of spending. The ratio of net investment in the economic system to accumulated capital in the economic system is the measure of the rate of profit/interest insofar as it is the result of these factors. In Capitalism, I call this ratio the “net investment rate.”

The rate of profit/interest in the economic system is explained by the combined operation of the net investment rate and one other rate, which I call the “net consumption rate.” Net consumption is the excess of spending for consumers’ goods over the wages paid by business firms. As explained, its primary source is the consumption expenditure of businessmen/capitalists. Net consumption is also equal to the excess of business sales revenues in the economic system over productive expenditure. Inasmuch as the expenditure to buy capital goods is present equally both in business sales revenues and in productive expenditure, the difference between sales revenues and productive expenditure reduces to the difference between the part of sales revenues constituted by consumption expenditure and the part of productive expenditure constituted by wage payments, i.e., net consumption.

Perhaps the simplest way to conceive matters is by starting with the fact that profit is the difference between sales revenues and costs. Sales revenues minus costs equals sales revenues minus productive expenditure plus productive expenditure minus costs. The first part of the result is net consumption; the second part is net investment. Thus, profit equals the sum of net consumption plus net investment. The further result is that the rate of profit, i.e., the ratio of profit to accumulated capital, equals the sum of the rate of net consumption plus the rate of net investment, with each of these rates being understood as the result of respectively dividing net consumption and net investment by the amount of accumulated capital in the economic system.

This theory of profit/interest has major implications for the understanding of capital accumulation, the determination of real wages and the general standard of living, taxation, inflation/deflation, and the business cycle. It also provides the basis for the overthrow of virtually all aspects of Keynesianism and its system of national income accounting, along with an equally fundamental and thorough refutation of Marxism and the exploitation theory.